depend on illustrations
models when helping
clients evaluate their life insurance
and investment needs. But common
mistakes during the modeling
process can mislead clients and
expose advisors to liability.
The illustrations and models
often show internal rate of return
(IRR) and pretax equivalent yield
calculations, but advisors sometimes
throw in shorthand calculations
that can produce inaccurate
results. The key is understanding
the asset types, the ownership
structures, and their corresponding income and estate tax
treatment for an accurate comparison of life insurance and
For example, if the asset is owned by an irrevocable trust,
it is also important to understand the gift tax implications.
For 2009, the first $13,000 gifted to any person (other than
gifts of future interests in property) is excluded from the total
amount of taxable gifts made during that year. A married
couple with two children can cumulatively give up to $52,000
($26,000 per beneficiary) per year without incurring a gift tax.
We will look at four strategies involving a case study.
A high-net-worth couple (ages
51 and 48) decide to designate
$50,026 per year, with the goal
of providing $10 million ($5
million each) after income and
estate taxes to their two children
at death. They are in good health
with a joint life expectancy of
45 years. If they survive to life
expectancy, they will give a total
of $2,251,170 (45 payments of
$50,026) over this period. Since
they have two beneficiaries and
can split gifts, the annual gifts
should avoid gift taxes. The
couple have already used their
lifetime gift tax exemption and
expect these assets designated for transfer to be subject to
the full estate tax if owned inside the estate.
Their goals can be accomplished in several ways, each with
different income and estate tax implications and long-term economic
results. The ideal method for transferring assets will likely
depend on the type of asset and the current ownership structure.
OPTION A Set up a joint securities trading account
with a financial institution and designate each child as a 50
percent beneficiary. The couple will contribute the $50,026
to the account on the first of each year.
Results: At death, the account assets will avoid probate
and receive a step-up in basis for income tax purposes.
The step-up in basis at death makes it possible for heirs to
inherit the property and sell it immediately with no income
tax on the unrealized appreciation before death. Therefore,
the unrealized earnings on appreciating assets are effectively
free of income tax (if held until death). Before death, gains
from dividends and account reallocations may be subject to
capital gains taxation if held over a year. The same may be
true for ordinary income if held for a shorter period. Maximum
capital gain tax rates are 15 percent, while ordinary
federal income tax rates go as high as 35 percent.
Depending on the asset, realized gains can be minimized
and the income tax liability on the asset appreciation can
be deferred if appropriately managed, and may be avoided
if held until death. However, estate taxes up to 45 percent
are still due on the total asset value at death. The account
must have a value at death of $18,181,818 to net $10
million to the children after the 45 percent tax. Assuming
realized gains are avoided during life and the assets receive
the step-up in basis at death, the account must yield 7.56
percent per year to produce the $18,181,818 account value
in year 45.
OPTION B Contribute $50,026 annually to a NQ
deferred annuity and designate each child as a 50 percent
Results: Nonqualified deferred annuities are income
in respect of decedent (IRD) assets. IRD assets generate
ordinary income that would have been taxable to
the decedent if it had been received by the decedent.
Therefore, IRD assets have income and estate tax implications.
For many people, IRD assets make up a significant
percentage of their net worth. IRD assets avoid probate
but are poor vehicles for passing wealth on to heirs. Many
IRD assets use pretax contributions, making the whole
account balance at death subject to income taxes and
NQ deferred annuities use after-tax contributions,
making the account balance at death subject to income
taxes on the inherent gains only and estate taxes on the
whole account balance. This double taxation is somewhat
mitigated with an IRD deduction for coordination of taxes.
Assuming a 35 percent income tax rate and 45 percent
estate tax rate (61 percent effective tax rate), the required
accumulation value to net $10 million to the children is
$25,768,085. The assets will need to earn 8.66 percent per
year to generate a $25,768,085 balance in year 45.
OPTION C Set up an irrevocable trust and make the
annual contributions to the trust. A trustee should be
designated and the children listed as the trust beneficiaries.
When each contribution to the trust is made, a Crummey
letter should be sent to the trust beneficiaries to qualify
the transactions as completed gifts for gift tax purposes
and to avoid inclusion in the estate of the grantor parents.
The trustee will allocate the contributions to an investment
Results: The trust agreement will usually dictate the
timing of the trust distributions instead of the death of the
grantors/insureds being the resolution event. Earnings and
dividends will be subject to tax at ordinary income or capital
gains tax rates. Estate taxes are avoided since these assets
are owned outside of the grantor's estate and there are no
incidents of ownership.
Using the same 45-year time horizon, the pretax equivalent
yield results will be dependent on how tax-efficiently
the assets were managed and the ultimate marginal tax
rate. Tax will be due at some point in the future even if all
earnings are deferred until the year of liquidation. If taxes
are deferred long enough, the impact of taxation is almost
completely mitigated. If all earnings are deferred for the 45
years and subject entirely to capital gains at 15 percent tax
rates, the required accumulation value is $11,367,441. The
pretax equivalent yield required is 6.03 percent.
The worst-case scenario occurs if all gains are realized and
taxable as ordinary income at 35 percent each year. This creates
a much different result of 8.61 percent pretax equivalent
yield. The actual comparable results will be somewhere
between the 6.03 percent and the 8.61 percent figures but
probably closer to the 6.03 percent pre-tax equivalent yield
if effectively tax managed.
OPTION D Similar to Option C above, except the trustee
will purchase survivorship life insurance on the grantors
and use the trust contributions to pay an annual premium of
Results: Life insurance receives favorable tax treatment
when compared to many other asset classes. One of the
advantages of life insurance is that there is no current
income taxation on earnings within the policy and the death
proceeds are received income tax free if held until death.
The second major advantage is the avoidance of estate taxes
on the life insurance proceeds if the policy is owned outside
the estate and there are no incidents of ownership. From a
planning perspective, the trust-owned life insurance strategy
is usually the desired solution if the IRRs on the insurance
are attractive because the other options require a higher rate
In addition, life insurance strategies provide enhanced
returns in the event of early deaths that other investment
strategies cannot provide, while also providing good longterm
stable returns if the insureds live to life expectancy.
At preferred nontobacco rates, a $50,026 annual premium
can purchase a $10 million level DB policy that has an IRR
at life expectancy of 5.60 percent. The major pitfall with the
trust-owned life insurance solution is that there are limitations
on how much money can be transferred to an ILIT each
year without gift tax due to annual exclusion and lifetime gifts
limitations. Many planners and attorneys try to avoid paying
gift taxes on additional assets transferred to trusts. Therefore,
once the annual exclusion gifts are maxed out, the question is
how to address any additional wealth transfer shortfalls.
The comparable pretax equivalent yield of a trust-owned
life insurance policy where 45 percent gift taxes are due on
gifts is 6.83 percent in year 45. Therefore, much of the value
of the trust-owned life insurance over the other alternatives
is diminished by the payment of gift taxes. Alternatively, if
the insurance is owned inside the estate, the couple's goals
will not be met, because 45 percent of the value will be lost
to estate taxes. Unfortunately, estate-owned life insurance
has no tax advantage over Option A because poor financial
planning or no planning can cause the loss of the estate tax
exclusion benefit normally available.
Pretax equivalent yield calculations are relevant when
comparing life insurance to other investments, because they
can take into consideration the different income and estate tax
treatment of various asset types and ownership arrangements.
However, these calculations can be complicated and results
misconstrued if care is not taken in conducting the analysis.
These calculations are often performed shorthand and can
provide misleading results. For example, many insurance
professionals incorrectly calculate the pretax equivalent
yield by dividing (1) the IRR of the life insurance by (2) one
minus the tax rate (income tax, estate tax or combined rate)
in order to get the required return on the alternate investment.
This calculation assumes taxes are imposed every
year instead of deferred until death. This incorrect pretax
equivalent yield calculation gets a result of 8.61 percent (calculation:
5.60% / (1 - 35%) = 8.61%). The calculation should
be made by dividing (1) the insurance death proceeds by (2)
one minus the tax rate to get the required pretax accumulation
value of the alternative investment. Then the IRR can be
calculated to show the true required compounded equivalent
rate of return. To do otherwise is to falsely assume that
the alternative investment is generating a tax liability every
year, when the taxes may be deferred until death.
Some industry professionals exacerbate the inaccurate
calculations when both income and estate taxes apply. If
the income tax rate is 35 percent and the estate tax rate
is 45 percent, some industry professionals show a pretax
equivalent yield of 15.65 percent. They take the 8.61 percent
pretax equivalent yield above and divide this number by one
minus the estate tax rate. The pretax equivalent rates for the
options described in the four options are significantly below
these amounts. By showing pretax equivalent rates this high,
the agent is inaccurately skewing the results in favor of the
life insurance solution.
When working with existing and prospective life insurance
clients, it is important to understand the tax treatments
of various asset classes during a lifetime and upon death to
ensure an optimal transfer of wealth to heirs. This will allow
the advisor to show various financial alternatives correctly
so the client can make an informed financial decision. Otherwise,
advisors may subject themselves to potential liability
if decisions are based on unsound economic projections due
to incorrect tax and timing assumptions and their signifi-
cant impact on assumed internal rate of return and pretax
equivalent yield results.